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The crisis in Catalonia probably won’t derail the Eurozone recovery. But there are more political challenges ahead.

Markets have largely shrugged off events in Catalonia, and they are probably correct to do so.

After all, Catalonia is unlikely to become independent, at least for the foreseeable future. There does not appear to be a majority in the region in favor of independence (although that could change). Constitutionally, Spain is a unitary, indivisible state, so there is currently no legal route to independence. And international opposition to independence, at the margin, makes it more difficult.

We are optimistic that that things shouldn’t turn ugly (again). Madrid appears to have belatedly realized the damage that the violent crackdown by the Spanish national police and the Guardia Civil has done to its moral authority. On the Catalan nationalist side, thankfully, there is no history of violent opposition equivalent to earlier armed Basque separatist groups.

Spain and the Eurozone can weather this crisis. There is some evidence that firms are moving out of Catalonia, although the scale of any exodus is open to dispute. Some are simply unscrewing their brass plates and moving head offices; others are reportedly relocating to other parts of Spain. It may also be that tourists avoiding Barcelona will head to other parts of Spain instead. That should limit the net impact on the national economy, which in any case appeared to be healthy going into this crisis. Meanwhile, Catalonia has shown no interest in leaving the euro, which may prevent any further escalation of events morphing into a systemic Eurozone crisis.

But this is not to say that there are no risks emanating from Catalonia. Fresh regional elections on December 21 could easily deliver a majority of seats to parties which favor independence. And deposed Catalan President Carles Puigdemont – were he to return to Barcelona - could become a rallying figure for the secessionist movement from behind bars.

Nevertheless, our best assessment is that the situation in Catalonia is more likely to be a thorn in the side of the Spanish and Eurozone economies, rather than a full-blown national and Eurozone-wide economic crisis.

Events in Catalonia serve as an important reminder that political risk has not gone away in Europe.

Elsewhere in Europe

More broadly, however, events in Catalonia serve as an important reminder that political risk has not gone away in Europe.

The most immediate worry is Italy, where an election has to be held by April 2018, and where the center-left Democratic Party and the anti-establishment, anti-euro Five Star Movement are neck-and-neck in the polls. The most likely outcome is an unstable grand coalition of the center-left and center-right (Berlusconi’s Forza Italia), which will do little to drive forward much-needed structural reform in Italy. But there is at least a chance of a populist coalition comprising the Five Star Movement, the Brothers of Italy and the Lega Nord. Such a coalition could attempt to hold a referendum on euro membership. Given Italy’s large stock of euro-denominated debt, this really would threaten a systemic Eurozone crisis.

Meanwhile, the reinvigorated Franco-German relationship may become less cordial once French President Emmanuel Macron starts presenting concrete policy proposals such as a European Monetary Fund to doubtful Germans.

Finally, a swathe of Eastern European countries are slowly drifting away from the traditional European principle of democratic pluralism. Hungary and Poland are becoming (in Hungarian Prime Minister Viktor Orban’s own words) “illiberal states.” Meanwhile, anti-immigration populists have made significant gains in recent elections in the Czech Republic as well as Austria. Another summer of large refugee inflows could drive a further wedge between East and West Europe.

You didn’t think European political risk was over, did you?

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